Variable Annuities Explained for the SIE Exam

A variable annuity is an insurance contract whose payments rise and fall with the performance of investments you choose — so unlike a fixed annuity, the contract owner (you) bears the investment risk. Because its value moves with the market, a variable annuity is both an insurance product and a security, which means selling one requires both an insurance license and a securities registration, and it comes with a prospectus. On the SIE — 75 scored questions in 105 minutes, passing score 70 — variable products sit in “Understanding Products and Their Risks,” the largest section at 44% of the exam.

Annuity basics

An annuity is a contract between you and an insurance company: you pay premiums — a lump sum or a series of payments — and the insurer promises to pay you an income stream, either right away or later. Most people use them for retirement.

Every annuity has two phases. In the accumulation phase, your premiums go in and the contract value grows tax-deferred — no tax on the interest or gains until you take money out. In the payout phase (annuitization), the insurer converts that value into periodic income, which can last a fixed period or for life.

Fixed vs variable: who bears the risk

Annuities come in two core types, and the difference is who’s on the hook for investment performance.

Fixed annuity. The insurer guarantees a set interest rate during accumulation and a fixed payment at payout. It’s backed by the insurer’s general account, and the insurer bears all the investment risk. Because the return and payout are guaranteed, a fixed annuity is an insurance product, not a security — no prospectus, no securities license needed to sell it.

Variable annuity. You choose the investment options (subaccounts), and your account value and payments vary with how they perform — so you, the owner, bear the investment risk. The money goes into a separate account, not the general account. Because of that investment feature, a variable annuity is both an insurance contract and a security. Selling one requires both a state insurance license and a FINRA securities registration (SIE plus Series 6 or 7), and it’s issued with a prospectus.

The one-line version: fixed annuity = insurer’s risk, guaranteed rate, insurance product; variable annuity = owner’s risk, performance-based, security and insurance.

The separate account and subaccounts

Variable annuity premiums are invested in a separate account — a portfolio legally segregated from the insurer’s general account and registered as its own investment company under the Investment Company Act of 1940. Within it, your money is allocated among subaccounts, which function like mutual funds: each holds a portfolio of stocks, bonds, or other assets. Pick a “large-cap equity” subaccount and your contract value rises and falls with that portfolio.

Because the separate account backs only the variable annuity contracts, its assets aren’t exposed to the insurer’s other liabilities. This is how a variable annuity delivers mutual-fund-style investing inside an insurance wrapper.

Accumulation units vs annuity units

You own units of the separate account — but what kind changes when you annuitize, and this is a top exam point.

Accumulation units (accumulation phase). Your contributions buy accumulation units, each representing a share of your chosen subaccounts. The value per unit moves daily with the investments, and the number of units changes too — it rises when you pay in or transfer, and falls when you withdraw. So during accumulation, both the number of units and the value per unit vary.

Annuity units (payout phase). When you annuitize, the insurer converts your total accumulation value into a fixed number of annuity units — set by your age, payout option, account value, and the assumed interest rate. From then on, the number of annuity units stays constant; only the value per unit changes with performance. Each payment equals your fixed number of annuity units times the current unit value.

The memory hook: accumulation units vary in number; annuity units vary in value.

The assumed interest rate (AIR)

The assumed interest rate is a benchmark the insurer uses to set your first annuity payment and adjust the ones after it. Think of it as the hurdle the separate account has to clear to keep your payment level. Each period, the insurer compares actual investment performance to the AIR:

• Performance above the AIR → unit value rises → the next payment increases.
• Performance equal to the AIR → unit value holds → the payment stays the same.
• Performance below the AIR → unit value falls → the next payment decreases.

The comparison is always against the AIR, not against last period’s return. Example: with a 4% AIR, if the subaccounts return 6% your next payment goes up; at exactly 4% it holds flat; at 2% it drops. The AIR is a target, not a guarantee — a higher AIR means bigger initial payments but a harder hurdle to clear afterward.

Payout options

At annuitization you choose how long payments last, and every added guarantee lowers the check:

• Straight life (life annuity) — the highest payment, but it stops at death with nothing to a beneficiary.
• Life with period certain — pays for life but guarantees a minimum number of years (say 10 or 20); if you die early, a beneficiary collects the rest of the period. Lower than straight life.
• Joint and last survivor — pays for two lives (you and a spouse), continuing to the survivor. Lower still, because it guarantees two lifetimes.
• Unit or cash refund — if you die before recovering your purchase price, the balance goes to a beneficiary. Lower than straight life.

The rule: more guarantees or longer payout = smaller periodic payment. Straight life pays the most precisely because it guarantees the least.

Taxation

Annuity tax rules (for nonqualified annuities, funded with after-tax dollars) are a favorite exam target:

• Tax-deferred growth. Earnings aren’t taxed until withdrawn.
• Ordinary income, LIFO. On withdrawal, earnings come out first (last-in, first-out) and are taxed as ordinary income — never at capital-gains rates. Only after all earnings are withdrawn does your tax-free principal come back.
• 10% penalty before 59½ on the taxable portion, unless an exception applies.
• Exclusion ratio at annuitization. Once income payments begin, each check is split into a tax-free return of basis and a taxable earnings portion. Put in $100,000 that’s grown to $200,000, and roughly half of each payment is tax-free until your basis is recovered, after which payments are fully taxable.
• No step-up at death. A variable annuity’s gains don’t get a stepped-up basis; beneficiaries pay ordinary income tax on the earnings — unlike, say, appreciated stock.

Fees, surrender charges, and riders

Variable annuities are known for high, layered costs: a mortality & expense (M&E) risk charge, administrative fees, and the subaccounts’ own expense ratios. Most also carry a surrender charge — a CDSC-style fee for withdrawing during an initial period (often 5–8 years) that starts high and declines each year. Together these make variable annuities considerably more expensive than mutual funds.

Optional riders add guarantees for extra cost. A death benefit rider guarantees a beneficiary at least your total premiums (sometimes a stepped-up value) if you die before payout. A living benefit rider (such as a GMIB) guarantees a minimum income or withdrawal level even if the investments perform poorly. Riders raise your guarantees and lower your net return.

Fixed vs variable at a glance

Feature	Fixed annuity	Variable annuity
Who bears investment risk	The insurer	The contract owner
Where premiums go	Insurer’s general account	Separate account (segregated)
Security status	Not a security (insurance only)	A security (registered, prospectus)
Licensing to sell	Insurance license only	Both insurance and securities licenses
Payment	Fixed and guaranteed	Varies with performance — can rise or fall

Both grow tax-deferred and are taxed as ordinary income (LIFO) on withdrawal.

Suitability and Rule 2330

Deferred variable annuities are complex, costly, and illiquid, so suitability is a serious concern. FINRA Rule 2330 governs their sale: the firm must gather detailed customer information and document that a variable annuity is appropriate versus the alternatives. Critically, a registered principal must review and approve (or reject) any recommended purchase or exchange — no later than seven business days after the firm’s office receives the complete application. Firms must also train reps on annuity features and maintain written supervisory procedures.

Variable annuity vs mutual fund. A variable annuity offers tax deferral and a death-benefit guarantee that a plain mutual fund doesn’t. But the trade-offs are real: mutual fund gains in a taxable account can be taxed at lower capital-gains rates and the shares sell any business day, while variable annuity earnings are taxed as ordinary income under LIFO, the fees are higher, and surrender charges lock you in. They’re sometimes called “mutual funds with insurance features,” but the tax and cost structures are very different.

Exam traps to avoid

• Who bears the risk. The owner bears investment risk in a variable annuity; the insurer bears it in a fixed annuity.
• Both a security and insurance. A variable annuity needs both a securities registration and an insurance license, plus a prospectus. A fixed annuity needs neither the registration nor the prospectus.
• Units. After annuitization, the number of annuity units is fixed and the value per unit varies. In accumulation, it’s the number of units that changes.
• AIR direction. Beat the AIR, the next payment rises; below the AIR, it falls; exactly the AIR, it holds.
• Taxation. Annuity earnings are ordinary income, not capital gains; withdrawals are LIFO; there’s no step-up at death.

Once fixed-vs-variable, AIR direction, the units distinction, and LIFO/ordinary-income taxation feel automatic, test yourself with the free SIE diagnostic to see how the SIE actually frames variable-annuity questions.

Frequently asked questions

What’s the difference between a fixed and a variable annuity?

A fixed annuity guarantees a set interest rate and fixed payments from the insurer’s general account, so the insurer bears the investment risk and your income is predictable. A variable annuity invests your premiums in subaccounts whose value fluctuates, so you bear the investment risk and your payments can rise or fall. A fixed annuity is purely insurance; a variable annuity is both insurance and a security, sold with a prospectus.

Who bears the investment risk in a variable annuity?

You do — the contract owner. The insurer doesn’t guarantee a return; your account value and future payments depend on how the separate-account subaccounts perform. If they lose money, your contract value and income drop. In a fixed annuity, the insurer bears that risk instead.

Is a variable annuity a security?

Yes. Because its value varies with investment performance, a variable annuity is a security, regulated by both state insurance authorities and securities regulators (the SEC and FINRA). Selling one requires both an insurance license and a securities registration, and it must be sold with a prospectus. Fixed annuities are not securities and need no prospectus.

What is the AIR?

The assumed interest rate is the benchmark used to set and adjust a variable annuity’s payments — the return the separate account must earn to keep a payment level. If actual performance exceeds the AIR, the next payment increases; if it falls below the AIR, the payment decreases; if it matches, the payment stays the same. With a 4% AIR, a 6% return raises the next check and a 2% return lowers it.

How are variable annuity withdrawals taxed?

Earnings are taxed as ordinary income, not capital gains. In a nonqualified annuity, withdrawals are LIFO — earnings come out first and are fully taxable, and only after they’re exhausted does your tax-free principal return. Withdrawals before age 59½ generally add a 10% penalty on the taxable portion. Once you annuitize, the exclusion ratio makes part of each payment a tax-free return of basis.

What’s the difference between accumulation units and annuity units?

During accumulation you own accumulation units, whose value fluctuates with the investments and whose number grows as you pay in. When you annuitize, they convert to annuity units, and the key difference is that the number of annuity units is then fixed — only the value per unit changes with performance. Your payment equals your fixed number of units times the current unit value.

The two hooks to carry in: in a variable annuity the owner bears the risk and it’s both a security and insurance — and after annuitization, the number of annuity units is locked while the value floats with the AIR. Get those, plus ordinary-income LIFO taxation, and the variable-annuity questions on the SIE go your way.